Osler Guide Income Trust Conversions

Osler, Hoskin & Harcourt LLP Table of Contents

Introduction ...... 3

Background ...... 4 A Change in the Landscape ...... 5

What Options Does a Trust Have? ...... 6 Maintaining the Status Quo ...... 6 Selling, Merging or Privatization ...... 6 Converting into a Corporation ...... 7

Methods of Conversion ...... 8 1. Share Exchange Method ...... 8 2. Share Distribution Method ...... 10 3. Other Variations ...... 11

Considerations ...... 12 Timing ...... 12 Nature of the Current Unitholder Base ...... 12 Effect on Existing Debt ...... 13 Effect on Existing Compensation Arrangements . . . .13 Effect on Existing Contracts and Licenses ...... 14 Cost ...... 14 The Logistics: How does it happen? ...... 14

How We Can Help ...... 15

2 Osler, Hoskin & Harcourt llp | Income Trust Conversions Introduction

The Canadian income trust market has always been defined by continual changes in Canadian tax rules. Beginning on January 1, 2011, the application of the Specified Investment Flow Through (SIFT) tax will effectively level the playing field between trusts and corporations, leaving the income trust structure with little, if any, tax advantage. Since being announced on October 31, 2006, the SIFT rules have forced trustees of income trusts to consider their strategic alternatives, considerations made all the more difficult by the recent unprecedented turmoil in the global banking system and a meltdown in the global capital markets.

Against this uncertainty, the SIFT rules have forced trustees to consider: • whether (or when) to convert into a corporation;

The purpose of this Osler Guide is • whether to pursue growth opportunities to review the available alternatives (within or outside the “normal” growth and to help set a framework for the limitations under the SIFT rules as described discussion that needs to happen below); and among all stakeholders when making these decisions. • whether to find a buyer and sell.

Osler, Hoskin & Harcourt llp | Income Trust Conversions 3 Background

Income trusts enjoyed booming popularity in before the announcement of the SIFT tax. This popularity arose from the tax advantage that they gained from being a trust, which effectively permitted them to distribute their available cash flow to unitholders with no (or a significantly reduced) entity-level tax.

The cash flow-through was accomplished The cash distribution provided an attractive through a number of variations on a basic income stream to retail investors, particularly structure by using vehicles that were (or could those who were past their prime capital be made to be) flow-through for entity-level tax formation years, that was not otherwise purposes. The following illustrates a simplified available from investments in traditional second generation income trust structure: equities issued by corporations. Trusts subsequently attracted an institutional following as mutual funds began including them in their portfolios. Public Income trusts were originally used in the energy and real estate industries. Starting in Fund 2000, more and more enterprises converted from a corporation into a trust to shelter themselves from corporate tax rates. At their peak in mid-2006, there were 245 income Trust trusts in Canada with a total market value of over $200 billion.

LP

4 Osler, Hoskin & Harcourt llp | Income Trust Conversions A Change in the Landscape In 2006, the prospect of several large been sold and a handful of larger trusts companies (including BCE) converting into (such as TransForce Income Fund, CI income trusts set off alarm bells in Ottawa, Financial Income Fund and Aeroplan and on October 31, 2006, federal Finance Income Fund) had converted back into Minister announced that he was corporations, in large part to gain greater implementing the SIFT tax to level the financial flexibility and access to capital playing field for trusts and corporations. The or, in some cases, to eliminate limits on SIFT tax applied immediately to new trusts, foreign ownership or to get out from and this effectively ended overnight any new under the growth limits imposed under trust conversion activity. Existing trusts the SIFT rules. Those trusts not sold or received the benefit of a deferral through the not re-converted in the short term chose end of 2010, but effective January 1, 2011, the instead to continue receiving the tax SIFT tax will apply to all distributions of benefit of the income trust structure as income from income trusts to unitholders. long as possible.

This unexpected change set off a wave of However, the time to act is quickly activity in the trust sector as trustees weighed approaching. The SIFT tax will apply their strategic alternatives and began to to all distributions of income beginning implement strategies to maximize unitholder in January 2011, and trusts will only be value prior to the implementation of the SIFT allowed to convert into corporations on a tax. By the autumn of 2008, many trusts had tax-deferred basis until December 31, 2012.

Effective January 1, 2011, the Specified Investment Flow Through tax will apply to all distributions of income from income trusts to unitholders.

Osler, Hoskin & Harcourt llp | Income Trust Conversions 5 What Options Does A Trust Have? There are three principal options available to existing trusts: • maintain the status quo; • sell, merge or privatize; or • convert into a corporation.

Maintaining the Status Quo Selling, Merging or Privatizing A trust can choose to maintain its trust While a sale or merger may initially have status. In doing so, it will become subject been a very feasible option in the days to the SIFT tax and effectively be subject to following the announcement of the SIFT corporate tax rates on the taxable , current market prices and the ongoing that it distributes to unitholders and to difficulty in obtaining acquisition financing personal tax rates (which are generally make a sale or merger a difficult prospect higher) on taxable income that it does not for many trusts. In some cases, privatizing a distribute. Trusts that are able to shelter trust by selling to institutional investors open taxable income (through the application of to maintaining the trust structure may be a tax pools) may choose to maintain the status viable alternative because private trusts are quo, at least until the end of the tax-free not subject to the SIFT tax on distributions. conversion period in 2012. Others may find However, in most cases, opportunities to that the advantages of conversion do not privatize remain very limited, except to the warrant the cost and so will simply proceed most successful of income trusts. after 2012 as a fully taxable income trust.

Trusts that are able to shelter taxable income (through the application of tax pools) may choose to maintain the status quo, at least until the end of the tax-free conversion period in 2012.

6 Osler, Hoskin & Harcourt llp | Income Trust Conversions Converting into a Corporation Converting into a corporation is an option The most often cited potential benefits open to all trusts. The number of announced of converting into a corporation include conversions is increasing, and a torrent of the following: conversions is expected in 2010. The most • a corporation is likely to have easier significant business trust conversions that access to capital, given the certainty have occurred to date provided the following of its structure and governance reasons for choosing to convert back to a requirements; corporation in advance of the application • a corporation may have access to a of the SIFT tax: broader universe of investors and • a corporate structure was better suited analyst coverage (as trusts have been to their growth strategy; considered as a separate class of • a corporate structure allowed for greater specialty investments); and access to financing; and • a corporation is not subject to tax • the trust’s valuation was at a discount at higher personal tax rates on taxable to growth-oriented corporate peers. income that is not distributed.

Key reasons for choosing to revert to being a corporation.

Osler, Hoskin & Harcourt llp | Income Trust Conversions 7 Methods of Conversion

Two basic methods are available to convert a trust into a corporation on a tax-deferred basis under the SIFT conversion rules: the Share Exchange Method and the Share Distribution Method

1. SHARE EXCHANGE METHOD Under this scenario, the units of the trust are exchanged for shares of a new corporation. The trust itself is wound up (together with any subsidiary trusts).

The following simplified charts illustrate the steps involved in a Share Exchange:

PRIOR TO SHARE EXCHANGE AND FINAL SHARE EXCHANGE WIND-UP DISTRIBUTION

Public Public Public

Newco Newco Fund Newco

Trust Fund LP

LP Trust • Public exchanges the units of the Trust for shares of Newco on a tax-deferred basis with LP no election required. • Under a Share Exchange, a new company (Newco) is incorporated. • The Trust is wound up and then the Fund is wound up within 60 days thereafter.

8 Osler, Hoskin & Harcourt llp | Income Trust Conversions One advantage of using a Share Exchange over a Share Distribution transaction is that the new corporation can access certain tax attributes of the Trust.

Conditions Certain conditions must be met for the To the extent that the fair market value automatic rollover to apply (and to eliminate of the units exchanged by a unitholder the need for the parties to file tax elections): exceeds the fair market value of the shares • the exchange must occur during a specified received by the unitholder and any part 60-day exchange period, at the end of which of the excess can be viewed as a benefit the new corporation owns 100% of the units incurred by a person with whom the of the trust; unitholder does not deal at arm’s length, • unitholders must dispose of all of their the excess will be an income inclusion trust units during this exchange period; to the unitholder. (In the case of a non- • unitholders must only receive shares of resident, such excess will be subject to Newco in return for their trust units; withholding tax.) • all unitholders must be issued the same Note that these fair market value issues class of Newco shares; and referred to above may, in turn, cause • the transaction must occur no later valuation issues that require a valuation than December 31, 2012. opinion, particularly where the new corporation holds assets other than the Unitholders are then deemed to have newly acquired units of the trust. transferred their units at a price equal to the tax cost of the units. To the extent that One advantage of using a Share Exchange the fair market value of the Newco shares over a Share Distribution transaction is received by a unitholder exceeds the fair that the new corporation becomes a market value of the units exchanged for such unitholder of the former trust. As a result, shares, there will be an income inclusion to the corporation can access certain tax the unitholder (in the case of a non-resident, attributes of the trust. such excess will be subject to withholding tax).

Osler, Hoskin & Harcourt llp | Income Trust Conversions 9 2. SHARE DISTRIBUTION METHOD Like the Share Exchange Method, the Share Distribution Method allows a trust to distribute to its unitholders on a tax-deferred basis the shares of a corporation owned by the trust. The trust (whose only asset can be shares of a taxable Canadian corporation) winds up and distributes the shares of that corporation to its unitholders.

The following simplified charts illustrate the steps involved in a Share Distribution:

EXISTING TRUST PRIOR TO SHARE DISTRIBUTION FINAL SHARE DISTRIBUTION

Public Public Public Public

Newco Fund Fund Fund

Trust Trust Trust LP

LP Newco Newco • The Trust is wound up and then the Fund is wound up within 60 days thereafter. • A new company (Newco) is • The shares of Newco incorporated by the Trust. LP LP will be distributed to the • The Trust transfers its Public on a tax-free basis in LP to Newco (no election is needed). on a tax-deferred basis (election has to be filed).

10 Osler, Hoskin & Harcourt llp | Income Trust Conversions To utilize the Share Distribution method, a trust that holds assets other than shares of a Canadian corporation must first restructure its affairs so that its only property consists of such shares.

Conditions 3. OTHER VARIATIONS Certain conditions must be met for the In addition to a Share Exchange and automatic rollover to apply (and to eliminate a Share Distribution, there are other the need for the parties to file tax elections): methods by which a trust may convert • the only property of the trust is shares into a corporation on a tax-deferred basis of a single class of a taxable Canadian that may be considered in specific corporation; circumstances. However, the critical • the distribution occurs no later factor in considering any structure is than December 31, 2012; that the conversion can be implemented on a tax-deferred basis. • the distribution occurs within a 60-day period; • all of the unitholders’ units of the trust are disposed of; and • there is a distribution of all of the trust’s property.

To take advantage of the Share Distribution Method, a trust that holds assets other than shares of a Canadian corporation must first restructure its affairs so that its only property consists of such shares.

Unlike a Share Exchange, a Share Distribution transaction does not result in the new corporation becoming a unitholder of the former trust. As a result, the corporation may not access the tax attributes of the trust.

Osler, Hoskin & Harcourt llp | Income Trust Conversions 11 Considerations

Deciding whether, when and by which method to convert a trust into a corporation involves a number of (often inter-connected) factors that should be reviewed within the context of a trust’s structure, business, tax position and distribution policy.

Timing Nature of the Current Unitholder Base The new SIFT tax does not come into play The nature of the trust’s unitholder base needs to for existing trusts until January 2011. As be examined. Initial investors in trusts typically such, any trust considering a conversion sought a regular return on their investment. before then needs to determine whether “Income” unitholders may choose to sell if there the benefits of becoming a corporation will be a fundamental change in strategy and outweigh the tax benefits available to a corporate policy post-conversion. trust pre-2011. Such a determination involves a consideration of the following Consideration must also be given to the tax questions: ramifications to both Canadian and non-resident • What are the actual tax savings that investors on conversion of a new business will be available to the trust and its structure. For example, in many cases it may be unitholders by postponing the possible to structure a trust conversion under either conversion? the Share Exchange or Share Distribution method as a tax-free rollover for U.S. unitholders. In each • Does the market price of the trust’s case, however, all of the particular circumstances of units reflect the value of the tax savings the conversion will need to be examined, including versus those of its non-trust peer group, the tax classification of the trust as a corporation, and what is the market “punishment” partnership or grantor trust for U.S. tax purposes likely to be for converting before the as well as the possible application of the U.S. trust is subject to the SIFT tax? passive foreign investment company rules, • Can the trust sustain its distributions before determining the actual consequences through 2011? of a conversion to U.S. unitholders. • What is the strategic vision for the entity and what distribution policy Income trusts are bound by certain foreign aligns with that vision? ownership restrictions and many have already • Are there benefits to implementing run up against their limit. However, no such a new corporate strategy earlier? restrictions apply to corporations (subject to any industry-specific ownership restrictions). As a result, the corporation should receive the benefit of increased liquidity.

12 Osler, Hoskin & Harcourt llp | Income Trust Conversions Effect on Existing Debt Effect on Existing Compensation Arrangements The specific terms of a trust’s debt Employment contracts signed by the trust may will need to be examined as part of any also have similar change of control provisions decision to convert. Generally speaking, that would trigger severance or change of bank and public debt contain restrictions control payments to employees on conversion on change of control transactions. A into a corporation. Careful consideration should number of questions are relevant when be given to how to deal with these provisions. examining the issue of existing debt: • Will the transaction trigger a In addition, the trust should examine its other repayment of the debt under any compensation arrangements (e.g., unit purchase change of control provisions? plans) and determine how they should be revised to reflect the new corporate structure. • Is any lender consent required for The trust should also reflect on the type of the transaction? Will the lender(s) securityholder approval required to implement require any amendments as a result such a new plan. of the new structure? • What will happen to the public debt? Will it be exchanged? Can the public debtholders force a “put” right? • Does the new tax position of the corporation have an impact on the corporation’s cash position and does it affect either its financial covenants Bank and public debt must be or its ability to service the debt? reviewed for restrictions on change of control transactions.

Osler, Hoskin & Harcourt llp | Income Trust Conversions 13 Effect on Existing Contracts and Licenses The Logistics: How Does it Happen? What will the impact of conversion be on the Most conversions to date have occurred by existing contracts and licenses to which the way of a plan of arrangement. The creation of trust is a party? Are there any change of Newco under each of the methods described control or assignment provisions in business- above allows the trust to access the applicable critical arrangements that will potentially corporate statutes’ plan of arrangement have a negative impact on the conversion procedures. This process requires unitholder itself or on the operation of the business approval, which requires a special meeting. going forward? Most arrangements provide for dissent Cost rights (and, to date, many conversions have Finally, the trust will have to assess whether provided such rights although, in practice, the costs (financial advisors, lawyers, meeting they have seldom been exercised). Yet, in an costs, management time, etc.) warrant the arrangement where the ultimate economic incremental benefits to be obtained by ownership does not change, it is unclear converting. whether dissent rights should automatically be granted in a conversion.

Most conversions to date have occurred by way of a plan of arrangement.

14 Osler, Hoskin & Harcourt llp | Income Trust Conversions How Can We Help?

Osler has extensive experience in providing advice on the strategic alternatives available to trusts. We draw upon the proficiency of legal practitioners in our Mergers and Acquisitions, Tax, Financial Services and Corporate Finance groups to ensure that the required expertise is brought to bear in executing strategic decisions. Our multi-jurisdictional capabilities in our offices in Toronto, Calgary, Montréal and New York allow our specialty groups to consistently provide outstanding client service.

Toronto Mark A. Trachuk Partner Tel: (416) 862-4749 Fax: (416) 862-6666 Email: [email protected]

Christopher S. Murray Partner Tel: (416) 862-6701 Fax: (416) 862-6666 Email: [email protected]

Calgary Frank J. Turner Partner Tel: (403) 260-7017 Deciding whether or not to Fax: (403) 260-7024 Email: [email protected] convert into a corporation may be the most challenging decision Montréal Ward A. Sellers the trust will have to make. Partner Tel: (514) 904-8116 Fax: (514) 904-8101 Email: [email protected]

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